BlackRock Trails State Street in Junk ETF Rally: Credit Markets

BlackRock Trails State Street in Junk ETF Rally
State Street’s ETF owns bonds that stand to lose more value if credit quality deteriorates or Treasury yields rise, Bloomberg data show. Photographer: Brent Lewin/Bloomberg

State Street Corp., manager of the second-biggest exchange-traded fund that invests in junk bonds, is beating larger rival BlackRock Inc. by buying riskier debt that’s outperforming the safest by the most since 2009.

The SPDR Barclays Capital High Yield Bond ETF has returned 9.6 percent this year, 1.2 percentage points more than BlackRock’s iShares iBoxx High-Yield Corporate Bond Fund. About 61 percent of the debt owned by State Street’s ETF, known by its stock ticker JNK, is ranked in the B tier or lower on Standard & Poor’s ratings scale, compared with 54.2 percent in BlackRock’s fund, holdings data compiled by Bloomberg show.

An economy growing just fast enough to avoid recession coupled with the Federal Reserve’s determination to keep interest rates at record lows is rewarding investors willing to buy bonds that have the greatest risk of default. That demand is allowing speculative-grade companies to borrow at a record pace, leading Bank of America Corp. analysts to warn last month that prices were reaching “bubble levels.”

“You need to peel back the hood of the car and look at the engine,” said Jason Rosiak, head of portfolio management at Pacific Asset Management, the Newport Beach, California-based affiliate of Pacific Life Insurance Co. “These high-yield ETF returns will diverge at times from the index and from each other.”

Riskiest Debt

Bonds rated CCC or lower have returned 14.9 percent this year, 4.25 percentage points more than the top tier of speculative-grade debt, according to Bank of America Merrill Lynch index data. Treasury yields dropped to a record 1.38 percent on July 25, and the Fed has kept its target rate for overnight loans between banks in a range of zero to 0.25 percent since 2008.

State Street’s ETF owns bonds that stand to lose more value if credit quality deteriorates or Treasury yields rise, Bloomberg data show. About 15.23 percent of its securities carry CCC grades, 2.73 percentage points more than BlackRock’s ETF.

High-yield ETFs, listed on exchanges and brokered like stocks, are growing at an unprecedented rate as the bond market stands to undergo the biggest transformation since the Financial Industry Regulatory Authority’s Trace trade-reporting system brought transparency to pricing in 2002.

Yield Spreads

The funds have amassed $31.8 billion in assets since the first one began five years ago, data compiled by industry-tracker ETF Database show, as the volume of corporate debt holdings among the biggest banks dropped 82 percent during the same period to $43.5 billion on Aug. 29.

Elsewhere in credit markets, Amgen Inc. joined Renault SA and five Spanish borrowers to raise money in the busiest day for European bond issuance in 2 1/2 years. Transocean Ltd., the owner of the oil rig that exploded in the Gulf of Mexico in April 2010, plans to sell debt in the U.S. to fund the building of four drillships.

The Markit CDX North America Investment-Grade index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, rose from a five-month low, climbing 0.9 basis point to a mid-price of 93.9 basis points as of 11:14 a.m. in New York, according to prices compiled by Bloomberg. The index rose from 93 basis points on Sept. 7, the lowest since April 4.

European Swaps

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings rose 3.7 to 129.9.

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million.

Bonds of Plains Exploration & Production Co. are the most actively traded dollar-denominated corporate securities by dealers today, with 47 trades of $1 million or more as of 11:07 a.m. in New York, Trace data show.

The Houston-based company’s bonds fell after it agreed to buy BP Plc’s interests in a group of Gulf of Mexico oilfields for $5.55 billion. The company’s $1 billion of 6.75 percent notes due February 2022 declined 2.5 cents to 106 cents on the dollar to yield 5.9 percent at 10:35 a.m. in New York, according to Trace.

Amgen, Renault

Amgen, the world’s largest biotechnology company, offered only its second notes in euros and pounds while French automaker Renault did its eighth public bond issue of the year, according to data compiled by Bloomberg. With deals from Spanish energy companies Iberdrola SA and Gas Natural SDG SA, the market was poised for about 10 billion euros ($12.8 billion) of issuance today, the most since March 11, 2010.

Transocean, the world’s largest offshore oil driller may sell five- and 10-year notes of benchmark size, typically at least $500 million, as soon as today, said a person familiar with the offering, who asked not to be identified because terms aren’t set. Proceeds may be used to construct four vessels with offshore drilling capabilities, Vernier, Switzerland-based Transocean said today in a statement distributed by Marketwire.

Junk bond ETFs, which have been around for five years, are gaining influence in a market that is generally traded off exchanges. They have attracted 22 percent of high-yield fund inflows since the end of 2009, EPFR Global data show.

Fund Flows

State Street’s ETF has grown to include about $12.1 billion of assets since its November 2007 inception, compared with $16.4 billion in BlackRock’s fund, which opened seven months earlier.

Investors have poured a record $9.935 billion into high-yield bond ETFs this year, almost three times as much as during the same period last year and greater than total inflows of $8.5 billion in 2011, according to London-based ETFGI LLP.

“We’re seeing a significant growth in people who are using ETFs to create entire portfolios,” said Deborah Fuhr, who helped found ETFGI after heading ETF research at New York-based BlackRock before leaving last year.

While both BlackRock and State Street’s funds seek to replicate the returns of specific indexes, their investment managers may choose a sampling of bonds they believe to best represent their benchmarks.

State Street’s ETF has returned 1.5 percentage points less this year than the Barclays Capital High Yield Very Liquid Bond Index that it seeks to track, while BlackRock’s fund is 1.8 percentage points behind its benchmark, the iBoxx Liquid High Yield Index, Bloomberg data show.

Ratings Divide

About 37.23 percent of the State Street fund’s holdings are rated BB, the highest speculative-grade tier, compared with 42.64 percent for BlackRock’s fund, according to the data. Last year, when notes with BB grades gained 6.1 percent and the lowest-rated bonds lost 1.4 percent, BlackRock’s fund returned 1.7 percentage points more than State Street’s, data from Bloomberg and Bank of America Merrill Lynch show.

“The quality of the bonds varies dramatically from one index to another,” said Gary Gastineau, managing director at ETF Consultants. “The further down the alphabet your rating is, the higher your probability of both default and loss on default.”

The State Street fund is taking more risk by buying bonds that have longer lives. Its assets have an average effective maturity of almost five years, about six months longer than the assets in BlackRock’s ETF, which trades under the ticker HYG.

Market Stimulus

That makes State Street’s fund more vulnerable to losing value if interest rates rise, while prone to gaining more when they fall. Troy Mayclim, a spokesman for State Street, said the money manager declined to comment.

“We definitely have seen investors using HYG and other fixed income ETFs to position portfolios in response to market conditions such as the Fed’s current low-interest rate policy,” Matthew Tucker, head of iShares Fixed Income Strategy team at BlackRock, said in an e-mailed statement.

Bonds with the lowest ratings are outperforming as policy makers buy debt to ignite a slowing worldwide economy.

European Central Bank President Mario Draghi announced an agreement on Sept. 6 for an unlimited bond-buying program to lower borrowing costs in the euro area and fight speculation of a currency breakup. Fed Chairman Ben S. Bernanke said last month that after $2.3 trillion of debt purchases in the U.S. by the central bank, more may be needed.

Record Pace

Speculative-grade borrowers have sold $206 billion of bonds in the U.S. this year, compared with $201.6 billion during the same period last year, Bloomberg data show. Sales are ahead of the $161.6 billion sold by this time in 2010, the year a record $287.9 billion of junk debt was issued.

Relative yields on the debt have contracted 149 basis points in 2012, Bank of America Merrill Lynch index data show, and there is “minimal scope for further rally in most of the high yield market,” Citigroup Inc. strategists Michael Anderson and Julie Pearson wrote in a Sept. 7 report.

BlackRock’s ETF has returned about a percentage point more than State Street’s since the end of 2007, Bloomberg data show.

“Over longer periods, I would expect them to have very similar returns looking at net asset values,” said Timothy Strauts, an ETF analyst at Morningstar Inc. in Chicago. “We’re going to need a little more time to figure out which one’s best.”


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